Bank of England Chief Mervyn King Proposes Eliminating Fractional Reserve Banking

Mervyn King - the governor of the Bank of England - has proposed abolishing fractional reserve banking.

As the BBC noted last week:

Mervyn King, the governor of the Bank of England, has tonight made a big intervention into the debate on banking reform. In a speech at Buttonwood, New York, he [listed] much more radical proposals.

1. Forcing the riskiest banks to hold capital "several times the magnitude" of requirements at present.
2. The Volcker rule-style enforced breakup of banks into speculative and non-speculative arms.
3. The "Kotlikoff proposal", which forces banks to match each pool of risks with a requisite amount of capital, preventing losses in one spilling over into another.
4. Stunningly, Mervyn King imagines the "abolition of fractional reserve banking":

"Eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not co-exist with risky assets."

King does not advocate any of these radical plans - but the fact that he goes out of his way to list them, and to place them on the agenda of the UK's Independent Commission on Banking, means that we are not yet at the end of the debate about long-term reform of the banks.

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Beyond the technicalities, the fact that a central banker in a G7 country is prepared to imagine such outcomes is itself significant.

Moreover, King wrote to Ben Dyson and stated:

You suggest that banks should be forced to conform to the underlying purpose of the 1844 Bank Reform Act. You might be aware that I have said publicly that I think ideas in this spirit - such as those advocated by John Kay - certainly merit serious consideration in the debate as to how we reform our financial system. I remain sympathetic to these views. But as I said in my previous letter, I do not want to prejudice the outcome of the Banking commission's deliberations. Now the Commission has been set up, I think we all should wait to see its conclusions."

As Dyson explains:

The 1844 Bank Charter Act ('Reform' is a typo) was a piece of legislation that prohibited commercial banks from printing paper notes (£1, £5, £10 and so on). Before this law was passed, banks were permitted to print as many paper notes as they wanted, up to the point where they printed too many and went bankrupt (as everyone cashed in their paper notes at once).

That situation should sound very similar to the situation that we have today - we currently allow commercial banks to 'print' money in the form of digital bank deposits (the numbers in your bank account). In the years up to 2007, the banks 'printed' far too much of this digital money, to the extent that they - and the economy - started to collapse.

The 'underlying purpose' of the 1844 Bank Charter Act was to prevent the commercial banks creating money and to restore that privilege to the state. It had become obvious to the government of the day that if banks were allowed to create money, they would keep creating money up until the point where it destabilized the economy, so they could not be trusted with this responsibility.

So, in plain English, Mervyn King appears to be saying:

"I agree that banks should probably be stopped from creating money, and recommend John Kay (or Laurence Kotlikoff's) proposals. But it's not for me to say - let's leave it to the Banking Commission."

It's very reassuring to know that the top guy at the Bank of England understands the root of the issue and is promoting solutions that would go a long way to addressing it. Both John Kay and Laurence Kotlikoff's proposals would prevent commercial banks from creating money (or 'issuing credit') for their own benefit at the expense of the wider economy and the public.

Ironically, while King is proposing the potential elimination of fractional reserve banking (i.e. a return to 100% reserves), Ben Bernanke has proposed the elimination of all reserve requirements (i.e. requiring no reserves):

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

Hat tip: Luis.